Globally, Government bonds worth around $16 trillion are now trading at negative yields, which is about one-third of the global bond market. This figure has almost tripled from October 2018.
People have always deposited their money with the government with the assurance of getting it back with interest. Now, they are paying governments to keep their money because they are becoming more and more desperate to find a safe place to store their wealth. Negative interest rates will result in even more worries about the state of the economy.
Investors have retreated to the safety of bonds due to worries about the slowing global economy and the impact of trade wars. Yields are also dropping because central banks are rushing to reduce interest rates, which is leading to a downward spiral.
Bond yields could keep falling until the trade wars end, or there are signs of improvement in worldwide growth. Low yields may be here for quite some time, and the process of unwinding them could be painful, especially if there is a sudden reversal.
Here we will look at what bonds with negative yields are and why investors choose them. We will also discuss what their side effects are and whether we are likely to see them in India.
What are negative interest rates?
One of the basic principles of finance is that the borrower pays interest to the lender. However, if the interest rate is negative, the opposite happens, and the lender pays interest to the borrower. For example, if you take a loan of Rs.10,000 from a friend and have to pay back only Rs. 9,500 in 5 years.
Typically, if you deposit money in a bank, you will get interest. However, if there is a negative interest rate, you will have to pay interest to the bank for keeping your money.
A Danish bank was in the news recently for introducing home loans with negative interest rates. Jyske Bank of Denmark introduced 10-year home loans with a negative annual interest rate of -0.5%.
Borrowers will pay their Equated Monthly Installments (EMIs), but the outstanding amount will fall by more than the EMI every month. So, the borrower will have to repay less than the borrowed amount.
Denmark is not the only country to have negative interest rates. Negative rates have existed for some time in Japan and several countries across Europe.
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Why are interest rates negative?
After the Global Financial Crisis of 2008, central banks cut interest rates to make people stop saving and start spending. They assumed that more spending would boost consumption and inflation and trigger an economic revival.
The European central bank reduced its deposit rate to less than zero in 2014, and Japan followed soon after. Central banks also started buying long-term bonds from the market, lowering interest rates further. Interest rates decreased even more because bond prices and yields move in opposite directions.
Low or negative interest rates help growth in two ways. Firstly, by lowering borrowing costs, and secondly, through currency depreciation. When a nation’s bonds offer negative returns, there is less demand for them. Lower demand for bonds causes currency depreciation, making exports competitive, and driving growth.
Why do investors buy bonds with negative yields?
1. Investors buy bonds with negative yields because they believe that the loss will be less than what it would be elsewhere.
2. Pension funds, insurance companies, and central banks have to own bonds to meet liquidity requirements.
3. Foreign investors think they can still make money as they expect the currency to rise, which would compensate for the negative bond yields.
4. Some investors expect deflation, which would permit them to use their money to buy more goods and services.
Do negative bond yields have any side effects?
- When government bonds offer negative returns, investors chase returns in risky assets like junk bonds and emerging market bonds/equities, which can create asset bubbles.
- It’s hard for banks to make profits because they have to pay borrowers to take loans. And it isn’t easy for them to get depositors to pay for keeping their money with them.
- Long-term investors, such as pension funds, are cutting their return expectations for the next few years. They are also switching to riskier assets to boost returns.
- Negative interest rates discourage savings by forcing people to pay interest for keeping their money in banks.
Will negative bond yields boost growth?
Governments need to provide a fiscal stimulus by increasing spending to boost economic growth. Many countries, including India, may not be able to increase spending because they already have too much debt or their deficits are high.
In such a situation, central banks start purchasing even more assets other than long-term debt. For example, the Bank of Japan is even buying equities.
Negative interest rates have not been able to turn around the economies of Europe and Japan. However, some people argue that these economies would have been much worse off without negative interest rates.
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Is India likely to have negative interest rates?
India is not likely to have negative interest rates because the 10-year government bond offers returns of more than 6% and inflation is at around 4%. Interest rates are expected to remain positive unless we experience sustained deflation (inflation rate falls below zero).
Interest rates in India are high compared to the rest of the world, and this will keep attracting foreign investors as long the Rupee does not depreciate.
India is still one of the fastest-growing economies in the world, even though signs of an economic slowdown are evident.
How this period of negative interest rates will end is uncertain. Positive returns are the basis of the financial system, and it may stop working if interest rates fall too low. A crisis of some sort will force governments to wake up and take action. Governments will have to stop depending on monetary policy and start using fiscal policy. Spending on infrastructure can stimulate the economy and raise interest rates. Companies with vast cash reserves can also begin to invest once demand improves.